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3. Alec LitowitzMagnetar CapitalThere are eclectic investors. And then there’s Magnetar Capital. The Evanston, Illinois–based, $14.75 billion firm, founded ten years ago by former Citadel global equity chief Alec Litowitz and co-founded by Glenwood Capital Investments president Ross Laser, focuses on three major areas: event-driven, fixed income and energy. Its individual investments range from financing aircraft to installing solar panels across the U.K. to, most famously, implementing an arbitrage strategy with collateralized debt obligations tied to mortgages.
Litowitz and his partners — including David Snyderman, who heads the fixed-income group, and Eric Scheyer, who oversees energy — have a reputation for seeking out investment opportunities that other firms may deem too complex and exploiting them in innovative ways. Sourcing such deals is not easy, but then, Litowitz has never been drawn to the path of least resistance. Born and raised in the suburbs of Chicago, he earned a dual MBA/JD degree from the University of Chicago and eventually joined Citadel, reporting directly to the hedge fund firm’s legendarily demanding founder, Kenneth Griffin. Before starting Magnetar, Litowitz spent two years competing in grueling Ironman triathlons; last year he completed a notoriously difficult mountain bike race in Costa Rica. Litowitz’s relentless quest for self-improvement and his strong aversion to the status quo are partly what drove him, along with his partners, to sell a stake in their firm to Blackstone Group in May. He says the deal will, among other things, help him motivate his employees, ultimately inspiring them to find even more innovative ways to invest.
Institutional Investor’s Alpha: What do you do to encourage innovative thinking at Magnetar?
Litowitz: That’s a by-product of the DNA of the firm. A lot of people would say it’s a bit tied to my personality — I have a fairly high dissatisfaction with the status quo, and I believe that it is easy for something to become obsolete and stale. So I think the answer to that is that it’s drilled in.
“Since the beginning we have structured our businesses to remove the barriers that often exist among various styles of investing.” — Alec Litowitz We have retreats that we do multiple times a year. With the retreats we want to be holistically thinking about the firm. It’s not just front office, it’s a broad retreat. Even on the infrastructure side, we want to make sure everybody’s treating it like a business. The retreats can be on-site or off-site — nowhere exotic, unfortunately. We don’t make them overly social. We almost always have a speaker who speaks to something that we want to convey. We had someone come who was one of the world’s best mountain climbers; he was talking about risk and how he has partnered with people. The decisions sometimes not to climb were part of how he got to where he is. We talk about the big picture and then where the underlying businesses are going. About a month later we do a town hall. Others and I say, “Here’s where we are headed,” so that everybody knows what we have decided for the next six months and the next 12 months.
It sounds like you are ultimately trying to get people to go out of their comfort zones — or maybe not to even have comfort zones.
It’s the irritant that makes the pearl; it’s a little bit like that. It can be frustrating for people, this constant questioning of “Are we doing the right thing?” That mentality is pervasive here. It can be tiring, but I think it goes back to the culture and finding people who also think like that. Take Dave Snyderman. You could argue that he has rebuilt his business multiple times. But the reality is he is constantly evolving it. It’s part of who we are to constantly question ourselves both informally and formally through these meetings.
You see it in the form of new businesses. We formed a U.K. solar company, raised $900 million, installed a million solar panels in the U.K., created that as an asset class, and now we can figure out how to finance that. If you are in the fixed-income business and all of a sudden there is a twinkle in your eye that solar is maybe interesting and then 12 months later you are one of the top U.K. players in solar, people realize that if you have a big idea, this is a place you can scale it up and get it done. That’s how you succeed at Magnetar, not by saying, “I’ve got a $50 million book and I think I can make big returns on my $50 million book.”
How does the firm’s structure help Magnetar to innovate?
At the basic organizational level, we have three pillars of the firm. Energy is one, event driven is another, and fixed income is another. We have a variety of underlying businesses; each of those in its own right has a broader set of underlying businesses. That’s the architecture from a front-office perspective. We have a variety of pillars, and within each pillar is a variety of strategies.
Since the beginning, however, we have structured our teams and businesses to remove the barriers that often exist among various styles of investing, like quantitative and qualitative, private equity and hedge fund, short and long duration, or control versus noncontrol. We invest across equity and credit, and in both public and private transactions. The ability to capture these types of opportunities requires a silo-less, collaborative culture.
You talk about how Magnetar likes “white-space opportunities.” Can you describe an investment niche you found or a problem you solved in an innovative way?
For me it’s about having an infrastructure and a platform. You have to try new things and fail. Not every asset class is going to work out. It may make returns, but it may not be scalable; you need working capital and human capital. Whatever asset class you pick and choose, you have to have a group that’s willing to migrate it. It doesn’t really matter who’s working on it; there needs to be swift movement and collaboration, and an attitude that change isn’t bad. It really is about adapting and growing with the business.
Think about the traditional fixed-income world. When we started the firm, back in 2005, if you looked around the universe and around the capital markets, there wasn’t an interesting capital structure arbitrage opportunity in corporates, but there was in mortgages. So that’s what we did. It’s not about saying we have a person in corporates and there’s not an opportunity there and they’re stuck. It’s about finding where there is a dislocation. There was a capital structure mispricing; we looked at a variety of asset classes, and mortgages provided the best opportunity.
At any given moment we are bringing in a variety of different asset classes — anything you can think about where there is a hard asset that needs some form of financing. We are looking across the board, and we are flexible. We don’t care per se what the asset class is as long as there is some competitive advantage that we can bring to the table. We are very agnostic on what asset class it is as long as we can wrap our minds around it. We like complexity; we think we’re pretty good at it.
And our hit ratio is not a high hit ratio. We leave on the table way, way more opportunities than we source and actually take in. An investment has got to meet a reasonable hurdle rate of return. The vast majority of things that we see we just pass on. But it’s not solely top-down — it’s where do we see a problem, where do we see people getting out of a business.
How do you source and evaluate these opportunities in an efficient way?
First, we built technology just to make things streamlined, so it’s not a bunch of people with spreadsheets that don’t talk to each other. We built a piece of software whose sole job is to help us filter through this sourcing. For literally every opportunity it allows us to track every aspect of the investment process. It’s all automated. There is no question of where are we in the process; it’s all input through a streamlined piece of software that was proprietarily built. That was a big investment we made. So that’s one.
Second is that we developed a quasispecialized expertise within Dave’s group. It’s a very senior group with a tremendous amount of skill and experience. They do have tendencies to group together in a function. There might be someone who spent a lot of time on mortgages and whole-loan mortgages. They might have a lot of relationships with people, and one of those people might have gotten a phone call where someone said, “I think there is an opportunity to buy a portfolio of homes in Ohio.” That was the Huber Heights investment. That comes through a network of relationships built off something else. Now, instead of a security with 750,000 homes, we’ve got a more narrow set of 2,000 homes. It’s the same skill level, but we need to do more-myopic underwriting; we’ve already got a skill set in that asset class. That’s pretty critical to have because it allows for a fairly quick filter. Think of Dave’s group as the first or second touch point: They know who are reliable sources, who are not; they have developed a bit of a sniff test. From a sourcing perspective it helps to have people who can do that. There are other asset classes that look a lot like regulatory capital trades. We’re ten years into sourcing opportunities in Europe; we’ve got a good idea of who to go to for sourcing opportunities in Spain, for example. And our contacts get a good idea of what we want.
The third aspect is over time you build up a network of people. I would say there are two external pieces to that part of the puzzle. One is the set of relationships that helps you source. The other aspect is, once you decide to go into a business, who do you partner with? Once you have internal efficiency through a process — with software for that, with a group internally that is quasispecialized — and then external people that you’ve built a network of, you wind up creating a universe of internal and external experts.
What role does innovation play when it comes to attracting and retaining talent?
We want people who do not have a silo mentality. We want people who come here because we are open to trying new things, but we do it in a methodical way so we are not throwing things at the wall. So the first factor is people selecting us. The second is one degree of separation. A lot of the people here are people we have known for a long time. Take [former Barclays head of markets] Eric Felder, who we just hired. There are people who have known Eric for 20 years. I’ve been speaking with Eric regularly for three to five years of that. I know Eric; I know his personality.
Part of it is the person’s character, and obviously you want the skill set. We really do want the combination. If you want a different type of experience, the type of environment where you are given a small amount of capital and you want to run the show, that’s something you’d do somewhere else. Here if you want to build a scaled business but do it in a collaborative way, that’s what excites us. You only do well for yourself here by putting the firm first and collaborating first.
If you look at the senior people at this firm, they are people who we knew before we hired them. It’s the vast, vast majority. So it’s building those relationships. Second, we want to incentivize them in the appropriate way. And over time we want more partners rather than fewer.
How has the hedge fund industry changed since you launched your firm? How are hedge funds today innovating in terms of the way they meet investors’ needs?
As pensions have grown, relationships have become more direct. That’s brought about some pretty drastic changes. When pensions come in, they want to deal with financial institutions; that means any firms of scale that have repeatable businesses and large infrastructures. That’s the first stage. That’s been going on for a few years. That’s the first-order effect.
There is a second-order effect that I think is going on right now. Prior to this incremental investor change, most of the relationship with the end client was through funds of funds. That worked fairly well. But it’s no surprise that some pensions have decided to go direct. For hedge fund firms it used to be that you had a product, you went through an intermediary, and they helped fit it to the end client. Now you have this translation problem: You are talking directly to the end client, and you need to figure out how to speak the same language.
The first question is, If I have a hedge fund product, where does it fit in with what the pension needs? They have these traditional asset-class buckets. Think of the proverbial long-short equity fund that’s 40 percent net long. Where does it fit? The world has now moved to thinking about things in factor space — if you will, taking away the asset class and saying, “What is the risk you want exposure to?” Say a pension has a bond portfolio. They could decide they want some other form of credit risk — direct lending, mortgages, consumer credit risk. They say, “I’m looking for something a little different.” It’s breaking down the asset class further into the risk or factor space.
There is another very large change coming about. Once you start thinking of hedge funds not as an asset class but as a means to round out desired exposures, you’ve got a question about where these factor or risk exposures fall. These risks or factors fall into categories that vary. Beta is very cheap and it’s very available. If an investor asks to have exposure to Japan, they can buy the Nikkei index for next to nothing. They can do it themselves. The next aspect, which is now a cliché, is smart beta. That’s basically saying: “I’m just going to reweight things. I was market-cap weighted, now I want equal weighted.” Or “I want value, not growth.” That was a buzzword a few years ago; it’s still a buzzword, but it’s a little misused. Maybe initially that was unique. That now is more broadly provided, and fees have started to come down for smart beta.
Then you have what we call alternative smart beta — a broad re-creating of what is traditionally an alternative asset class. Think of the risk arbitrage business. A deal gets announced; there is a probability of the deal going through or not. A manager can buy the stock and take on the risk of the deal breaking. He looks at all the risk arb deals at any one time and puts a bunch of them on — that’s an asset class. And the reality is because he’s an insurance provider (in the sense that he’s creating a diversified risk pool), the market pays him a premium for that.
Compare that with a pure alpha book, where the manager looks at that universe of risk arb deals and decides which are going to go through and which are going to break. Now he’s applying another set of skills to filter that down to create differentiated skill. So beta is easy, smart beta is reweighting, and then there’s alternative smart beta and then pure alpha. If you look at those definitions, the questions are, Where and how do those fit into the end client’s portfolio? What do you get paid for just being in converts? With the technology that’s being brought about by the proliferation of smart beta, investors can now look at any hedge fund returns and decompose them and see how much of that return is from just being long the market, how much is from just being exposed to an asset class and how much is from being exposed to a return on something else.
Once investors have that Rosetta stone where they have the ability to dissect and decompose returns, that is going to result in changes to fees and the creation of a whole new set of products with different fee structures than existed before. At the end of the day, the larger fee structures are going to be reserved for real production of alpha. And if you look at firms that are generating pure alpha through skill, maybe the right fee is above 2 and 20. The other might be a return on labor — you get paid because you can source the opportunity. The other is return on labor for differentiated structuring that provides a differentiated return profile. There are examples of this at our firm.
Let’s talk about the Blackstone deal. How does your partnership with Blackstone encourage innovation at Magnetar and help with recruiting?
It’s unquestionable that they have a tremendous brand. They now have multiple products in multiple channels that they’ve been highly successful with. We talked about expanding into different businesses; they have done a tremendous job of that. As we expand, their experience and insight into what worked and what didn’t as they expanded becomes incredibly valuable.
The second thing is that when you have a stake, there are two things you can do with that. You can redeploy the cash. And in addition to that, once you strike a valuation, you can use that to recruit talent. We now have a currency, and that allows us to add new partners, and in the case of our senior people who have done a very good job of building businesses internally, migrating them into either being partners or further aligning them with the growth or diversification of our business and high quality of investment returns. That’s much easier to do when you have stamped a valuation on the firm. That gives us that incentive to encourage people to try new businesses, to think through what they are doing. Those are two very big aspects that we thought about in coming to the decision to sell a stake.
